Last week's Options 101 article proposed a method of testing trades available to almost all options traders: running what-if scenarios. Many trading platforms allow traders to adjust the date, price of underlying and volatilities, and I believe CBOE's trade simulator may do so, too. These testing tactics provide enough information for the trader to theorize how a specific trade might perform under many possible conditions.

Of course, theory doesn't always match reality. While this week's market behavior did not exactly replicate the what-if scenario posited in last week's article, a sharp price drop and rising implied volatilities did gift us with a chance to look at how well last week's what-if test fit the trade's performance. First, let's review the original hypothetical trade as set up on July 22, with commissions and $0.18/contract in slippage built in.

Iron Condor with Composite Options and Their Deltas, OptionNet Explorer Chart:

The article then looked at the current VIX. Next, the article considered past behaviors of the VIX and the SPX after the VIX had obtained the levels that were then current. A test was set up for conditions under which the SPX dropped five percent and implied volatilities rose about six percentage points, all in a 22-day period.

What-If Scenario for Dropping SPX Prices and Rising Implied Volatilities, Chart by OptionNet Explorer:

In this scenario, sharply rising implied volatilities had dropped the profit-and-loss (PnL) line below the zero line. A five-percent drop in the SPX price after the trade entry would have brought the SPX to about 1,884.35. Last week's article explained that scrolling across the chart to SPX 1884.35, the loss would have been about $480.

To review the process involved in deciding upon and then setting up this hypothetical test, you can review last week's article. Obviously, 22 days haven't yet passed since July 22. That wouldn't occur until Wednesday, August 13, as depicted on the second chart. Neither has the SPX yet dropped to the 1,884.35 level that would have represented a five-percent drop from the July 22 level.

The SPX had dropped sharply but only to 1,933.18 at the time the following charts were snapped. Neither have the composite implied volatilities risen six percentage points from their 10.67 percent level on July 22. Instead, they rose only to 13.47 percent at the time the following charts were snapped, not quite three percentage points.

However, the SPX has dropped sharply from its July 22 level, the composite implied volatilities in the SEP options have risen, and time has passed. It's possible to check the PnL as of the morning of Friday, August 01, and determine if the direction of changes we're seeing on the PnL chart are the kind that would have been predicted by the what-if scenario that had been tested.

Current PnL for Hypothetical Iron Condor as of Friday, August 1, Chart by OptionNet Explorer:

We can see that the rise in composite implied volatilities has indeed dropped the PnL line below the zero line, as the what-if scenario had predicted. Because the implied volatilities have not yet risen as much as the what-if scenario was testing, the line hasn't dropped as far below the zero line as it had in the what-if test. However, the theoretical unrealized loss has deepened, even if not as much as it would have if the SPX price had continued dropping on the left-hand side of the hill drawn by the PnL chart or if implied volatilities had risen more. Still, the direction of the changes, if not yet the amplitude of those changes, was consistent with what was predicted by the what-if test.

In last week's article, a single SPY long put, bought at the inception of the trade, was considered as a price and volatility hedge. Was its performance consistent with what would have been expected, based on the scenario?

Current PnL for SPY 180 Put, as of Friday, August 1, Chart by OptionNet Explorer:

The drop in the SPX's (and SPY's) price and the rise in implied volatilities had begun producing some profit in the SPY hedge, offsetting the loss in the iron condor. As mentioned in the prior article, the adjustment guidelines I used when trading iron condors would have had me adjusting prior to Friday, August 1. I adjusted based on the deltas of the sold options and would have adjusted when the delta of the sold put reached -16, particularly with the non-farm payrolls numbers expected before the market open on Friday, August 1.

This article was not meant to suggest possible adjustments, however. It was meant to follow up on a technique for testing trades when traders don't have the capability to back-test their trades. Although the SPX has not (yet, at least) hit the what-if scenario's five-percent loss, implied volatilities have not (yet) hit the what-if scenario's level, and the time frame of the what-if scenario has not yet been fulfilled, this week's actions allowed for a double-check of this method of running what-if scenarios and learning how a trade might react. The direction of the changes do prove to be as expected.

This method is also useful for traders making decisions when trades are on the cusp of needing an adjustment but perhaps not quite there. Traders can create what-if scenarios for the next day or days, including the scenarios they believe most likely. However, traders should also include a scenario for times when their suppositions are proven wrong and prices and volatilities head the opposite direction.

Linda Piazza